Buy the Dips for Bright Horizons (BFAM)

I have been following Bright Horizons (BFAM) on and off for years now, back in 2015 I even had a post arguing why an expensive stock works for them.

The problem is I never bought. I kept waiting and waiting for a "cheap enough" valuation that never arrives. A few years later the stock has tripled, while that long awaited recession never came either. (Yes it’s beyond frustrating.)

Here I would recommend accumulating BFAM on the next 10-15% pull back.

Summary Upside

• Sustained high single digit/low double digits top line growth.
• Margin boosts from operating and financial leverage.
• Ability to roll up small operators using high price stocks = "equity leverage" / reflexivity.
• Option to open up centers to unsponsored families.
• Possibility of franchising /capital light model in the future.
• Stability from solid free cash flows. 

Summary Downside

• Corporate sponsored model would be hit in a recession
• Trend toward smaller companies and work from home could hurt BFAM

Business
Bright Horizons operates almost 1,100 child care centers, about 70%/30% split between North America and Europe. North American centers have an average capacity of 126 children per location. European centers can cater to 81 children per location.

Instead of going direct to consumer, the company finds employers who want to subsidize childcare for employees. Typically the employer builds the center, while BFAM manages the operation.

The employer based model allows BFAM to attract parents/kids in bulk, so the company enjoys efficient sales and marketing costs. But it exposes BFAM to the job market as well as trends in corporate market.

• Anecdotally, there is political will to rein in, or even break up big corporations, the type that’s most likely to provide these childcare benefits.
• In general there is a trend toward smaller companies or startups – these are less likely to be BFAM clients.
• The trend is also for more working from home / remotely. Both would decrease the need for child care centers near office sites
• M&A among clients can lead to consolidation of work force or child centers. This can lead to closures for BFAM.

BFAM has two operating models for real estate. In the employer sponsored model (that’s most centers), an employer sponsor funds the development and ongoing maintenance of the center, and BFAM has an operating contract to manage the center. In the lease/consortium model, BFAM leases the property itself.

Next, let’s take a look at valuation and analyze if BFAM can grow into the valuation.

Valuation
After several years of unsuccessful waiting, I’m starting to think BFAM’s valuation is not so bad.

A nice chunk of capex is growth capex. If you deduct only maintenance capex, management says they expect ~$250mm-$275mm of free cash flows for 2019.

So at ~$130.5/share or $7.6bn market cap, this is about 29x FCF. That’s actually not too bad in today’s environment, if growth can continue for the next few years.

Remember, this is the sort of consumer facing stock that never gets cheap. If fundamental performance holds up, floor multiple is probably around 20x FCF. If that FCF grows ~15% a year (which it does right now), then in 3-4 years this grows into floor valuation – i.e. you get your principal back and the rest is upside.

An expensive stock actually juices earning growth for BFAM, as it allows management to pay for acquisitions accretively (e.g. buying a center that has earning yield of 10% and pay with stocks that yield 3% will grow your EPS). It's also a competitive advantage whether BFAM is trying to enter a new market or further build out its presence in existing markets and go for local density.

Despite fairly frequent acquisitions, management did a great job the past few years keeping debt controlled while using buybacks to decrease share count.

But let’s be very clear - this is a valuation that requires growth, so that's what we will discuss next.

Drilling down on growth
There are 4 sources of revenue growth. The first three increases enrollments: 1) new centers, 2) natural ramp, 3) cross selling. The last is price increases.

• New centers. This could be new employer clients, or existing clients adding locations. Going to market via corporations requires a dedicated sales force.
• Cross selling. One way to do this is to add backup care to existing full service centers to increase utilization. BFAM can also open up its existing centers to non-employer sponsored families.
• Natural ramp of existing centers (takes 4 years to reach full utilization)
• Price increases. Could be 3-4% a year.

The company has a long way to grow before fulfilling its total addressable market (TAM). In the latest earning call, management estimated that there are about 14,000 work sites in the U.S. that could use an onsite childcare center. To put that in context, BFAM has less than 800 centers in U.S. now.

Looking at these drivers, I’m fairly comfortable that Bright Horizons can continue to grow its revenue. With its operating and financial leverage, margins should increase as well. Sure, a recession could hit, but that would be a temporary setback as opposed to the end of growth.

How Bright Horizons Can Navigate a Recession

The only worry is corporate clients scaling back, which BFAM is especially vulnerable to in a recession. This is why I never liked their corporate focused model, even while fully acknowledging its benefits.

Ultimately though, BFAM has options. In a recession if corporations pull back, it’s possible for BFAM to 1) take over the real estate responsibilities, 2) open up to non-corporate sponsored public.

Most sites operate under the employer sponsored model where employers own or lease the property. In the event that an employer client want to close down its location, BFAM can take over the real estate, perhaps by bringing in a triple-net provider like STORE Capital (where STORE would own the real estate and lease to BFAM).

In that case Bright Horizons can keep the center open, but will still lose employee clients and employer subsidies, so BFAM would have to open up the center to the public and charge parents full price. But child care demand should be fairly consistent even in a recession. As long as BFAM can keep utilization at an adequate level, it can keep cost and price under control.

Even more drastically, BFAM can pursue the direct to consumer channel and do it via franchising. It certainly has a strong brand name it can leverage.

In conclusion, BFAM has years of growth ahead. It's not immune to a recession, but it has plenty of options to mitigate a recession's impacts and perhaps come out stronger. I believe the stock can grow into its expensive looking valuation.